Commentary and musings on the complex, fascinating and peculiar world that is securities regulation

Friday, March 18, 2011

Broad Support Building for Legislation Creating US Covered Bond Market

Bi-partisan legislation creating a US covered bond market has been introduced in the House and is supported in principle by the Obama Administration and a key member of the Senate Banking Committee. Covered bonds have been used in Europe for decades to help provide additional funding options for the issuing institutions and are a major source of liquidity for many European nations’ mortgage markets. The purpose of the United States Covered Bond Act of 2011 (HR 940) is to create a legislative framework for U.S. covered bonds, which are securities issued by banks and backed by pools of loans that enable credit to flow more readily from the capital markets to individuals and small businesses in a way that enhances stability of the broader financial system.

Covered bonds, a form of debt issued by a financial institution, represent an innovative source of private mortgage market financing. The issuer of the bond is responsible for the risk posed by the underlying pool and maintains the bond on its balance sheet. That is different from the current U.S. mortgage system, where lenders sell many of the loans they make to Fannie Mae and Freddie Mac, which then repackage them as securities for investors. The core elements of the legislative framework are legal certainty for covered bond programs and oversight by federal regulators. The legislation was introduced by Rep. Carolyn Maloney (D-NY) and Scott Garrett (R-NJ), Chair of the Capital Markets Subcommittee.

Speaking in support of the legislation, Financial Services Committee Chairman Spencer Bachus (R-Ala) said that covered bonds are an innovative source of financing that has worked well in many European countries, particularly in the aftermath of the financial crisis when many other traditional credit channels were badly disrupted. In his view, covered bonds would provide much needed liquidity in capital markets while at the same time representing a private market solution to the need for market participants to have skin in the game.

At a recent hearing before the Senate Banking Committee, Treasury Secretary Tim Geithner said that the Administration backs efforts to create a market for covered bonds for financing mortgages that would help wean the mortgage market from government support. At the hearing, Senator Charles Schumer (D-NY) said that he may introduce a companion bill in the Senate.

The FDIC has warned that a covered bond system could put its bank deposit insurance fund at increased risk for losses because the investors would have seniority over the agency in the event of default. Secretary Geithner said that the FDIC concerns are legitimate and would have to be worked out. "For this to work, you would be putting the taxpayer in some sense behind private investors, and that has its own consequences, but that is something we can work through and I think it can play a greater role in our system," he said.

Covered bonds are essentially a securitization device widely used in other countries. But they have failed to catch on in the United States. In a covered bond system, banks can borrow against the value of the underlying mortgages to obtain fresh capital to extend further loans. The bond investors have the right to those underlying assets in the case of a bank default.

A covered bond is a debt obligation issued by financial institutions and secured by a pool of high-quality mortgages or other assets. Covered bonds are the primary source of mortgage funding for European banks. These instruments are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank.

Legislation typically specifies the types of collateral permitted in the cover pool, defines a minimum over-collateralization level, provides certainty of principal and interest payments to investors in the case of insolvency, and requires disclosures to regulators or investors or both. In addition, the government generally provides strong assurances to investors by having bank supervisors ensure that the cover pool assets that back the bonds are of high quality and that the cover pool is well managed.

Covered bonds also help to resolve some of the difficulties associated with the originate-to-distribute model. The on-balance-sheet nature of covered bonds means that the issuing banks are exposed to the credit quality of the underlying assets, a feature that better aligns the incentives of investors and mortgage lenders than does the originate-to-distribute model of mortgage securitization. The cover pool assets are typically actively managed, thereby ensuring that high-quality assets are in the cover pool at all times and providing a mechanism for loan modifications and workouts. Also, the structure used for such bonds tends to be fairly simple and transparent.

Currently, the US does not have the extensive statutory and oversight regulation designed to protect the interests of covered bond investors that exists in European countries. The legislation would fill this gap by requiring the Secretary of the Treasury to establish an oversight program that would prescribe minimum overcollateralization requirements, identify eligible asset classes for cover pools, and create a registry to enhance the transparency of covered bond programs. The banking agencies would carry out the Treasury-prescribed oversight program. A critical portion of the bill deals with an issuer’s default on its covered bond obligations, and the procedure for dealing with the covered bond program of an issuer in receivership.

A critical portion of the bill deals with an issuer’s default on its covered bond obligations, and the procedure for dealing with the covered bond program of an issuer in receivership. The bill calls for the transfer of the assets of the pools securing the covered bonds out of the receivership estate and into a separate estate solely for the benefit of the covered bondinvestors.

Any covered bond issued or guaranteed by a bank will be treated as a security issued or guaranteed by a bank under section 3(a)(2) of the Securities Act and section 3(c)(3) of the Investment Company Act, as well as section 304(a)(4)(A) of the Trust Indenture Act. No covered bond issued or guaranteed by a bank will be treated as an asset-backed security as defined in section 3 of the Securities and Exchange Act.

Thus, any estate created must be exempt from all securities laws but must be subject to the reporting requirements established by the applicable covered bond regulator and must succeed to any requirement of the issuer to file periodic information, documents, and reports in respect of the covered bonds as specified in section 13(a) of the Securities and Exchange Act or rules established by an appropriate federal banking agency. Similarly, any residual interest in an estate that is or may be created must be exempt from all securities laws.

In a statement submitted to the Committee, the FDIC expressed significant concerns with the proposed legislation. The FDIC believes that the legislation fails to maintain the important balance between investor demands and government exposure, providing investors with lopsided benefits at the direct expense of the Deposit Insurance Fund. H.R. 940 would muddy the relationship between investors and regulators, transfer some of the investment risks to the public sector and the fund, and provide covered bond investors with rights that no other creditors have in a bank receivership. In addition, the FDIC believes that HR 940 will primarily benefit large complex financial institutions

The FDIC said that the regime set up by H.R. 940 creates an implied subsidy to financial institutions and investors that does not exist for any other privately issued security. The bill provides for a new class of risk free investments by giving covered bond investors protections in the form of an unfettered claim on significant amounts of collateral that would be unavailable to any other creditors. This structure will skew the market, limit the demand for long-term, stable unsecured debt, and thwart the nascent efforts to enhance market discipline in the wake of the financial crisis.

In addition, the proposed bill would make the federal prudential regulators the appointing and supervising authority of trustees that would operate the separate estates of the covered bonds. This level of government entanglement in what are private contractual matters could also lead to an implied guarantee of covered bonds that would put covered bonds on a near par with the government-sponsored enterprises, said the FDIC, a status that should not be granted without strong policy reasons. It would also make the FDIC avirtual guarantor to covered bond investors.

In the view of FDIC, the super-priority given covered bond investors by the proposed legislation also runs against the policy direction established by Congress in recent legislation. In 2005, for example, Congress enacted Section 11(e)(13)(C) of the FDI Act, which prohibits secured creditors from exercising any rights against any property of a failed insured depository institution without the receiver’s consent for the first 90 days of a bank receivership. This provision prevents secured creditors from taking and selling bank assets at fire sale prices to the detriment of the receiver and the DIF.

More recently, Section 215 of the Dodd-Frank Act mandates a study to evaluate whether a potential haircut on secured creditors could improve market discipline and reduce cost to the taxpayers. This study was prompted by the recognized roles that the run on secured credit and the insatiable demand for more collateral had in the financial crisis. In contrast, the unprecedented protection in the covered bond bill for one form of secured creditors, covered bond investors, runs counter to the policies underlying these provisions

A further FDIC concern created by the proposed legislation is that it could encouragecovered bond transactions that include triggers for early termination or default before a bank is closed by the regulators. Under the proposed bill, a separate estate, which removes the entire cover pool from the bank’s control, is created upon any event of default. Once created, the separate estate and all collateral in the cover pool would be outside the control of the FDIC, as receiver for the bank.

The residual value of the pool, and all of the loans, would be outside the receivership and be lost for all other creditors of the failed bank. In the FDIC’s view, this additional special protection creates a strong incentive for covered bond transactions to include a trigger that acts before the bank is placed into receivership.

The FDIC said that it would support covered bond legislation that clarifies the amount of repudiation damages to be the par value of outstanding bonds plus interest accrued through the date of payment. This provides a remedy that fully reimburses the covered bond investors.